Introduction
The Dodd-Frank Act requires most swaps to be traded on an exchange or on a similar system and then guaranteed by a clearinghouse, where the parties would be required to post collateral.
Up for decision by Treasury under Dodd-Frank is whether or not “foreign exchange swaps” or “foreign exchange forwards” or both should be exempted from the definition of a swap under the Commodity Exchange Act. Treasury has asked for public comment on this on or before December 27, 2010.
Two recent comment letters have come in to Treasury that are of interest. The first and shorter one came in from the Investment Company Institute (“ICI”) and will be the subject of this Article. There was a much longer comment letter from the Foreign Exchange Committee, an industry group consisting of bank FX dealers and a few large instituitional and corporate buyers that will be the subject of a second article.
ICI Comment
Generally, the ICI viewed it as premature to make comments since many details of how "swaps" are to be regulated are yet to be formulated.
However, the ICI did make two preliminary recommendations.
The first recommendation was that “FX Spot” transactions, which in any event are not swaps in the view of the ICI, and foreign exchange transactions with a short settlement cycle (settlement by payment within 6 days or less of a trade date), should not included within the definition of a “swap” subject to regulation.
The ICI characterized these short term trades as being non-speculative transactions entered into for the purpose of hedging currency risk on international business transactions and/or on the repatriation of foreign dividends for investments in overseas companies. The ICI letter also said that collateralization of spot transactions (which would be required if these transactions were treated as a regulated “swap”) was not market practice and would present challenges of frequency of valuation, transfers of collateral, and collateral returns essentially not worth the compliance in view of the relatively low risk involved.
The second recommendation was that the term “foreign exchange forwards” should include non-deliverable FX forwards [i](“NDF’s") . ICI was concerned that the definition of the term “foreign exchange forwards in Dodd-Frank could be interpreted to include only deliverable trades because it mentions the “exchange” of two different currencies. Non-deliverable FX forwards are cash settled in just one currency and do not involve the exchange of underlying currencies.
The ICI is concerned that if Treasury ultimately determines to exclude “foreign exchange forwards” from the definition of swap but does not make it clear that non-deliverable FX forwards are considered as “foreign exchange forwards” that it would force the markert to have to deal with the legal possibility that non-deliverable FX forwards were not excluded from being defined as “swaps” and hence were still subject to regulation as swaps. In the view of the ICI this would be an anomalous result as non-deliverable swaps pose conisderably less risk than deliverable swaps because principal amounts are not exchanged.
In short, the ICI letter focuses on systemic risk as being minimal. However, one does wonder how profitable these products are for the dealers and how transparent and how wide the dealer mark up and mark downs are - not to mention commissions, alhough I would imagine commissions to be transparent enough. So I would love to see a disussion of the transparency aspect of the products vis-a-vis need for regulatory oversight.
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Robert Kiggins, Esq. of McCarthy Fingar LLP, is author of the blog, and may be reached at (914) 385-1024 or rkiggins@mccarthyfingar.com.
Nothing is this blog is intended to or may be relied upon as specific legal advice. Securities and related laws are complex and competent counsel should be consulted
[i] Overview
A Non-Deliverable Forward (NDF) FX transaction is an FX Forward hedging mechanism where the physical exchange of currency at expiry is replaced by settlement between counterparties of the net profit/loss on the contract, calculated using the prevailing Spot Fixing Rate two days prior to settlement. The net settlement will occur in a predetermined convertible currency, typically USD.
An NDF is used when the client needs to hedge against a currency that does not have a deliverable market offshore, including Taiwan Dollar (TWD), Korean Won (KRW), Chinese Yuan (CNY), Brazilian Real (BRL), and Argentinean Pesos (ARS).
No exchange of principal.
No upfront fee.
Example
XYZ Company imports telecommunication equipment from a Brazilian supplier at a cost of BRL 3 million. XYZ Co. is invoiced and payment is due in 180 days (t+180). The supplier wishes to be paid in USD in an amount equivalent to BRL 3 MM. Thus XYZ Co., and not the supplier, is exposed to exchange rate fluctuations.
| XYZ Co: | Buys BRL / Sells USD |
| Amount: | BRL 3.0 MM |
| Forward NDF Rate: | 0.7690 |
| Scenario 1: | NDF Hedge is In-the-Money |
| Spot Fixing Rate: 0.8000 |
At maturity XYZ Co. has the obligation to buy BRL 3.0 MM from Square 1 Bank at the rate of 0.7690 compared to the spot fixing rate of 0.8000. However, since BRL is a non-convertible currency, the net amount will be settled in USD.
To settle the NDF, Square 1 Bank will make a payment of USD 93,000 to XYZ Co. on t+180. The amount is calculated as follows from the perspective of XYZ Co:
(BRL 3.0 MM * 0.8000) - (BRL 3.0 MM * 0.7690) = USD 93,000
XYZ Co. benefits from the hedge despite the strengthening of BRL and can budget that the net cost of the equipment will be, in dollar terms, USD 2.307 MM. XYZ Co. will then have Square 1 Bank wire to the Brazilian supplier USD 2.4 MM and XYZ Co. will also receive USD 93,000 from Square 1 Bank. The net of the payments equals the budgeted amount of USD 2.307 MM. The supplier will then convert the USD to BRL with its own bank.
| Scenario 2: | NDF Hedge is Out-of-the-Money |
| Fixing Rate: 0.7410 |
At maturity XYZ Co. has the obligation to buy BRL 3.0 MM from Square 1 Bank at the rate of 0.7690 compared to the fixing rate of 0.741. However, since BRL is a non-convertible currency, the net amount will be settled in USD.
To settle the NDF, XYZ Co. will make a payment of USD 84,000 to Square 1 Bank on t+180. The amount is calculated as follows from the perspective of XYZ Co:
(BRL 3.0 MM * 0.741) - (BRL 3.0 MM * 0.7690) = - USD 84,000
XYZ Co. will have Square 1 Bank wire USD 2.223 MM to the Brazilian supplier and will pay USD 84,000 to Square 1 Bank. The sum of the payments equals the budgeted amount of USD 2.307 MM. The supplier will then convert the USD to BRL with its own bank.
Considerations
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Easily implemented for both future foreign payables and receivables.
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Eliminates adverse fluctuations to currency exposure and locks in an exchange rate as of trade date.
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Easily implemented as a series of forward NDF transactions for recurring FX hedging needs such as payroll.
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NDFs are moderately liquid and transparent foreign exchange hedging tools.
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Allows a client to keep allocated cash in its main operating currency until the time of settlement.
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Provides fixed hedges for foreign line items impacting budgeted financial statements and increases accuracy to pro forma financial statement building.
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Minimal sovereign/convertibility risk. Minimal dependence on local markets, except for fixing.
